By Anthony Diosdi
The major purpose of an income tax treaty is to mitigate international double taxation through tax reduction or exemptions on certain types of income derived by residents of one treaty country from sources within the other treaty country. Because tax treaties often substantially modify United States and foreign tax consequences, the relevant treaty must be considered in order to fully analyze the income tax consequences of any outbound or inbound transaction. The United States currently has income tax treaties with approximately 58 countries. This article discusses the United States- Switzerland Income Tax Treaty.
There are several basic treaty provisions, such as permanent establishment provisions and reduced withholding tax rates, that are common to most of the income tax treaties to which the U.S. is a party. In many cases, these provisions are patterned after or similar to the United States Model Income Tax Convention, which reflects the traditional baseline negotiating position. However, each tax treaty is separately negotiated and therefore unique. As a consequence, to determine the impact of treaty provisions in any specific situation, the applicable treaty at issue must be analyzed. The United States- Switzerland Income Tax Treaty is no different. The treaty has its own unique definitions. We will now review the key provisions of the United States- Switzerland Income Tax Treaty and the implications to individuals attempting to make use of the treaty.
Definition of Resident
The tax exemptions and reductions that treaties provide are available only to a resident of one of the treaty countries. Income derived by a partnership or other pass-through entity is treated as derived by a resident of a treaty country to the extent that, under the domestic laws of that country, the income is treated as taxable to a person that qualifies as a resident of that treaty country. Under Article 4 of the United States- Switzerland Income Tax Treaty, a resident is any person who, under a country’s internal laws, is subject to taxation by reason of domicile, residence, citizenship, place of management, place of incorporation, or other criterion of a similar nature. Because each country has its own unique definition of residency, a person may qualify as a resident in more than one country. Whether a person is a resident of the United States or Switzerland for treaty purposes is determined by reference to the internal laws of each country.
The term “resident of the United States” means: 1) a business entity formed in the United States, or 2) any other person (except a corporation or any entity treated under United States law as a corporation) resident in the United States for purposes of United States tax, but in the case of an estate or trust only to the extent that the income derived by such person is subject to United States tax as the income of a resident. Section 7701(b) of the Internal Revenue Code treats an alien individual as a U.S. resident where such an individual is 1) lawfully admitted for permanent residence, (26 C.F.R. Section 301.7701(b)-1(b)(1)) “Green card test:” An alien is a resident alien with respect to a calendar year if the individual is a lawful permanent resident at any time during the calendar year. A lawful permanent resident is an individual who has been lawfully granted the privilege of residing permanently in the United States as an immigrant in accordance with the immigration laws. Resident status is deemed to continue unless it is rescinded or administratively or judicially determined to have been abandoned.”) (2) meets the substantial presence test, (An individual meets the substantial presence test with respect to any calendar year if i) such individual was present in the United States at least thirty-one days during the calendar year, and ii) the sum of the number of days on which such individual was present in the United States during the current year and the two preceding calendar year (when multiplied by the applicable multiplier: current year – 1, first preceding year – ⅓, second preceding year – ⅙) equals or exceeds 183 days) or iii) makes a first year election.
In contrast to the U.S. law, residence for Swiss tax purposes is defined as the place where a person stays with the intention of settling permanently with the intention of settling permanently and therefore provides the center of personal and business interests. A person will also be considered a resident if they remain in Switzerland for a continuous period of more than 90 days (without gainful activity) or 30 days (with gainful activity such as employment) in a calendar year. Switzerland taxes its residents on their worldwide income, with exception of income from foreign permanent establishments and real estate situated abroad. Individuals are regarded as residents within Switzerland with the intention of staying there permanently.
Nonresidents are treated as residents for tax purposes if they are residing in Switzerland and are performing a gainful activity. Nonresidents staying in Switzerland but not performing a gainful activity are also treated as residents after they have been in Switzerland for more than 90 days. Taxes are governed by federal law and 26 cantonal tax laws. The latter may differ greatly from each other. Additionally, in most cantons communal and parish or church taxes are levied as a percentage of cantonal taxes, and each commune independently determines its own percentage.
An individual who is a resident of both Contracting States shall be deemed to be resident of that Contracting State in which he maintains his permanent home. If he has a permanent home in both Contracting States or in neither Contracting State, he or she shall be deemed to a resident of that Contracting State with which his or her personal and economic relations are closest (center of vital interests). While Article 4 of the treaty looks to each country’s laws to define the term “resident,” Because each country has its own unique definition of residency, a person may qualify as a resident in more than one country. Whether a person is a resident of the United States or Switzerland for treaty purposes is determined by reference to the internal laws of each country.
For example, an alien who qualifies as a U.S. resident under the substantial presence test pursuant to U.S. tax law may simultaneously qualify as a resident of Switzerland under its definition of resident. To resolve this issue, the United States has included tie-breaker provisions in the United States- Switzerland Income Tax Treaty. The tie-breaker rules are hierarchical in nature, such that a subordinate rule is considered only if the superordinate rule fails to resolve the issue. Article 4(3) of the United States- Switzerland Income Tax Treaty provides the following tie-breaker for individuals:
a) An individual shall be deemed to be a resident of that Contracting State in which he maintains his permanent home. If he has a permanent home in both Contracting States or in neither of the Contracting States, he shall be deemed to be a resident of that Contracting State with which hios personal and economic relations are closest (center of vital interests);
b) If the Contracting State in which he has his center of vital interests cannot be determined, he shall be deemed to be a resident of that Contracting State in which he has a habitual abode;
c) If he has an habitual abode in both States or in neither of them, he shall be deemed to be a resident abode in both States or in neither of them, he shall be deemed to be a resident of the State of which he is a national;
d) If he is a national of Both States or of neither of them, the competent authorities of the Contracting States shall settle the question by mutual agreement.
Below, please see Illustration 1 which provides an example how a treaty-tie breaker can be analyzed and resolved.
Illustration 1.
Paul is a citizen and resident of Switzerland. Paul owns SwissCo, a company incorporated in Switzerland that is in the trade or business of taking over corporations. SwissCo is in the process of expanding to the much more lucrative U.S. market by opening a branch office in the United States. Paul is divorced and maintains an apartment in Zurich, Switzerland, where he spends every other weekend visiting his children. Paul’s first wife, who kept their house in their divorce, has never left Switzerland. Paul becomes a U.S. resident alien under the substantial presence test as he operates SwissCo’s U.S. branch. In the United States. Paul owns a luxury condominium in Miami, Florida where he lives with his second wife.
Because Paul is considered a resident of both the United States and Switzerland, the treaty tie-breaker procedures must be analyzed to determine which country has primary taxing jurisdiction. With an apartment in Switzerland and a condominium in the United States, Paul has a permanent home available in both countries. With Paul’s children and his home office in Switzerland as opposed to the lucrative portion of his business and his new wife in the United States, Paul does not have a center of vital interests in either country. Furthermore, Paul regularly spends time in both countries, he arguably has a habitual abode in both. As a result, under the treaty tie-breaker, Paul may be considered a resident of Switzerland because he is a citizen of Switzerland.
Business Profits and Permanent Establishment
A central issue for any company exporting its goods or services is whether it is subject to taxation by the importing country. Most countries assert jurisdiction over all the income from sources within their borders, regardless of the citizenship or residence of the person receiving that income. Under a permanent establishment provision, the business profits of a resident of one treaty country are exempt from taxation by the other treaty country unless those profits are attributable to a permanent establishment located within the host country. A permanent establishment includes a fixed place of business, such as a place of management, a branch, an office, a factory or workshop. A permanent establishment also exists if employees or other dependent agents habitually exercise in the host country an authority to conclude sales contracts in the taxpayer’s name.
Article 5 of the United States- Swiss Income Tax Treaty defines a permanent establishment as a fixed place of business through which a resident of one of the Contracting States engages in industrial or commercial activity. This includes the following: 1) a set place of management; 2) a branch; 3) an office; 4) a store or other sales outlet; 5) a factory; 6) a workshop; 7) a mine, quarry, or other place of extraction of natural resources and 9) a building site or construction or assembly project or supervisory activities in connection therewith, provided such site, project or activity continues for a period of more than 12 months.
A permanent establishment shall be deemed not to include any one of the following:
1) The use of facilities solely for the purpose of storage, display, or occasional delivery of goods or merchandise belonging to the resident;
2) The maintenance of a stock of goods or merchandise belonging to the resident solely for the purpose of storage, display, or occasional delivery;
3) The maintenance of a stock of goods or merchandise belonging to the resident solely for the purpose of processing by another person;
4) The maintenance of a fixed place of business sol;ely for the purpose of purchasing goods or merchandise, or for collecting information, for the resident; or
5) The maintenance of a fixed place of business solely for the purpose of advertising, for the supply of information, for scientific research, or for similar activities which have a preparatory or auxiliary character, for the resident; or
Marketing products in either the United States or Switzerland solely through independent brokers or distributors does not create a permanent establishment, regardless of whether these independent agents conclude sales contracts in the exporter’s name. In addition, the mere presence within the importing country does not create a permanent establishment. Please see Illustration 2 and Illustration 3.
Illustration 2.
USAco, a domestic corporation, markets its products through the internet to Swiss customers. Under the United States- Switzerland Income Tax Treaty, the mere solicitation of orders through the internet does not constitute a permanent establishment. Therefore, USAco’s export profits are not subject to income tax in Switzerland.
Illustration 3.
USAco decided to expand its Swiss marketing activities by leasing retail store space in Zurich, Switzerland in order to display its goods and keep an inventory from which to fill foreign orders. Under the United States- Switzerland Income Tax Treaty, USAco’s business profits would still not be subject to Swiss income taxation as long as USAco does not conclude any sales through its foreign office. However, if USAco’s employees start concluding sales at the Zurich office, USAco may have a permanent establishment in Switzerland.
Personal Services Income
United States- Switzerland Income Tax Treaty provisions covering personal services compensation are similar to the permanent establishment clauses covering business profits in that they create a higher threshold of activity for host country taxation. Generally, when an employee who is a resident of one treaty country derives income from services performed in the other treaty country, that income is usually taxable by the host country. However, the employee’s income is typically exempted from taxation by the host country if the employee is present in the host country for 180 days or less.
Income from Real Property
Tax treaties typically do not provide tax exemptions or reductions for income from real property. Consequently, both the home and host country maintain the right to tax real property. Article 7 of the United States- Switzerland Income Tax Treaty provides that income derived by a Swiss resident from U.S. real property may be taxed in the United States and vice-versa.
Dividends, Interest, and Royalties
Article 10 of the United States- Switzerland Income Tax Treaty discusses the taxation of dividends. The term “dividends” as used in the treaty means income from shares, mining shares, founders’ shares or other rights, not being debt-claims, participating in profits, as well as income from other corporate rights assimilated to income from shares by the taxation law of the State of which the corporation making the distribution is a resident. Under the treaty, the rate of tax imposed by one of the Contracting States on dividends from sources within the Contracting State by a resident of the other Contracting State shall not exceed:
a) 5 percent of the gross amount of the dividend if the beneficial owner is a company which holds directly at least 10 percent of the voting stock of the company paying dividends; or
b) 15 percent of the gross amount of the dividends in all other cases.
Article 11 of the United States- Switzerland Income Tax Treaty deals with the taxation interest. Article 11(1) of the treaty states that interest derived and beneficially owned by a resident of a Contracting State shall be taxable only in that State. The term “interest” as used in the treaty means income from debt-claims of every kind, whether or not secured by mortgage, and in particular, income from government securities and income from bonds or debentures, including premiums and prizes attached to such securities, bonds or debentures, and including an excess inclusion with respect to a residential interest in a real estate mortgage investment conduit. Penalty charges for late payment shall not be regarded as interest for the purpose of the treaty.
Under the treaty, interest derived by a resident of one of the Contracting States from sources within the other Contracting State shall not be taxed by the other Contracting State at a rate in excess of 15 percent of the gross amount of such interest.
Article 12 of the United States- Switzerland Income Tax Treaty discusses the taxation of royalties. Article 12(1) of the treaty provides that royalties derived and beneficially owned by a resident of a Contracting State shall be taxable only in that state. The term “royalties” as used in the treaty means payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic, or scientific work (but not including motion pictures, or films, tapes or other means of reproduction for use in radio or television broadcasting), any patent, trademark, design or model, plan, secret formula or process, or other like right or property, or for information concerning industrial, commercial, or scientific experience. The term “royalties” also includes gains derived from the alienation of any such right or property which are contingent on the productivity, use, or disposition thereof.
Pensions
Article 19 of the United States- Switzerland Income Tax Treaty discusses the taxation of pensions. The United States-Swiss Income Tax Treaty provides favorable language providing tax exemption in the host country for home country pension contributions. However, this exemption lasts for assignments for up to five years. The United States-Swiss Income Tax Treaty provides that dividends paid to a pension plan situated in the other country are exempt from tax in the home country, provided that the Internal Revenue Service (“IRS”) and the Swiss taxing authority agree that the plan correspondences to a pension plan in the other country. The United States- Switzerland Income Tax Treaty exempt U.S. based pension plans such as 401(k), 403(b), and 457(b) plans from taxation. This exemption is extended to Individual Retirement Accounts (“IRAs”). This treaty provision not only potentially allows Swiss residents to withdraw U.S. based retirement accounts without incurring U.S. withholdings, it also allows U.S. residents investing in a Swiss company via their U.S. 401(k) plan to potentially avoid Swiss withholding at source on any dividends paid. See RSM, Recently Ratified Treaty Protocols Impact Taxation of Pension Plans (November 11, 2019).
The Anti-Treaty Shopping Provision (Limitation on Benefits)
For an individual to be eligible for treaty benefits, the individual must be considered a resident of the particular treaty country and must satisfy any limitation on benefits (“LOB”) provisions in the treaty. Under the U.S.-Switzerland Income Tax Treaty, an individual will be considered a resident for treaty purposes if such person is “liable to tax therein by reason of its domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of a similar nature.” Under the treaty’s LOB provision if that resident is an individual, or a corporation that is at least 30 percent of the aggregate vote and value of all shares are persons that are residents in that Contracting State or the ultimate beneficial owners of more than 70 percent of all such shares are residents of member states of the European Union or parties to the North American Free Trade Agreement.
Thus, for example, if 100% of the common stock of a U.S. company (representing 100 percent of the voting power in, and 95 percent of the value of, the company) was owned by a Canadian company, it generally would be entitled to benefits of the treaty with respect to the Swiss source income. However, if the remaining five percent of the value of the company consisted of a class of stock that paid dividends determined by reference to the income derived from the U.S. company’s Swiss subsidiary and 50 percent or more of the value (or vote, if relevant) of the class of stock were held by a resident of a third country that does not have a double tax treaty with Switzerland, the U.S. company would not be entitled to benefits of the U.S.- Switzerland Tax Treaty.
A corporation that is not entitled to the benefits of this treaty pursuant to the provisions discussed above may qualify for treaty benefits if the corporation is traded on a “recognized stock exchange” such as NASDAQ or the stock exchanges of Amsterdam, Frankfurt, London, Milan, Paris, Tokyo, or Vienna. Even if an individual is not publicly traded, it can still qualify for treaty benefits if it passes the “active conduct of trade or business” test. The active conduct of a trade or business need not involve manufacturing or sales activities but may instead involve services. However, income that is derived in connection with, or is incidental to, the business of making, managing or simply holding investments for the resident’s own account generally will not qualify for benefits under the treaty.
Below, please see Illustration 4 as example intended to clarify how these rules are intended to operate:
Illustration 4.
P, a holding corporation in Switzerland, is owned by three persons that are residents of third countries. P has a participation of 50 percent in the Swiss resident P-1, which performs all of the principal economic functions related to the manufacturer and sale of widgets and midgets in Switzerland. P, which does not conduct any business activities, also owns all of the stock and debt issued by R-1, a United States corporation. R-1 performs all of the principal economic functions in the manufacture and sale of widgets in the United States. R-1 purchases midgets of midgets in the United States and neighboring countries. P-1’s activities are substantial in comparison to the activities of R-1.
In this example, treat benefits may be obtained by P on the payment of dividends or interest from R-1. The income received by P from R-1 is derived in connection with P’s active and substantial business (through P-1) in Switzerland. For this purpose, 50 percent of P-1’s activities may be attributed to P since P owns a 50 percent participation in P-1. The same result would occur if R, a wholly owned United States subsidiary of P, owned all of the stock and debt of R-1.
Disclosure of Treaty-Based Return Positions
Any taxpayer that claims the benefits of a treaty by taking a tax return position that is in conflict with the Internal Revenue Code must disclose the position. See IRC Section 6114. A tax return position is considered to be in conflict with the Internal Revenue Code, and therefore treaty-based, if the U.S. tax liability under the treaty is different from the tax liability that would have to be reported in the absence of a treaty. A taxpayer reports treaty-based positions either by attaching a statement to its return or by using Form 8833. If a taxpayer fails to report a treaty-based return position, each such failure is subject to a penalty of $1,000, or a penalty of $10,000 in the case of a corporation. See IRC Section 6712.
The Income Tax Regulations describe the items to be disclosed on a Form 8833. The disclosure statement typically requires six items:
1. The name and employer identification number of both the recipient and payor of the income at issue;
2. The type of treaty benefited item and its amount;
3. The facts and an explanation supporting the return position taken;
4. The specific treaty provisions on which the taxpayer bases its claims;
5. The Internal Revenue Code provision exempted or reduced; and
6. An explanation of any applicable limitations on benefits provisions.
If an individual would like to take a treaty position (such as a claim that the U.S.- Switzerland Income Tax Treaty exempts a U.S. based retirement plan from U.S. taxation), a detailed statement must be stated on the Form 8833.
Conclusion
The U.S.-Switzerland Income Tax Treaty provides a number of planning opportunities for cross-border tax planning. The U.S.-Switzerland Income Tax Treaty also permits individuals working in one of the two countries to deduct or exclude their contributions to a pension or other retirement plans for taxation. The benefits of the U.S.-Switzerland Income Tax Treaty is subject to certain conditions such as the treaty’s LOB. Anyone considering utilizing the U.S.- Switzerland Income Tax Treaty for cross border tax planning should consult with a qualified international tax attorney.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.